THE INVESTMENT

ANALYSIS

CHAPTER SEVEN –MODELS FOR

SELECTING VIABLE PROJECTS
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Evaluation criteria
• Now that the methods for estimating the cost of capital have been
examined, we can consider how the cost of capital is relevant in
the capital budgeting process.

• Ultimately, managers must decide whether to invest in new

projects or not.

• Once the preliminary stages of estimating the cash flows,

assessing the relevant risks and estimating the cost of capital
have been performed, some criterion or decision rule must be
applied in making the investment decision.
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Discounting methods of investment selection

• The non-discounted criteria failed to take into
account adequately the timing of benefits.

• We know that variations of costs and benefits

influence their values and a time adjustment is
necessary before aggregation.

• Therefore, a time dimension should be included in

our evaluation.

• That means we need to express costs and benefits by

discounting all items in the cash flows back to year 0.

• The need for such a procedure will be apparent if one

considers the following simple argument.
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Discounting methods…
• Suppose one is offered the choice
between receiving Birr 100 today and
receiving the same amount in a year’s
time. It will be rational to prefer to receive
the money today for several reasons.

• One may expect inflation to reduce the

real value of Birr 100 in a year’s time.

• If there is no inflationary effect it would

still be preferable to take the money today
and invest it at some rate of interest, r.
Hence, receiving a total of Birr 100 (1+r)
at the end of the year.
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Discounting methods
• Even if no investment opportunities are available, Birr
100 today would still be preferable on the grounds that
there is a high risk of not being around to collect the
money next year.

• Even where inflation, investment opportunities, and risk

are ignored, there is pure time preference, which would
lead one to prefer the immediate offer

• Due to the above reasons, there is a positive rate of

discount, which leads us to place a lower value on a
given sum of money that will be received some times in
the future.
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Discounting methods
• The most important discounted cash flow measures
include
• The Net Present Value (NPV)
• The Internal Rate of Return (IRR)and
• The Benefit Cost Ratio (BCR)
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1. Net Present Value (NPV)

• The net present value of a investment is the sum of the

present values of all the net cash flows that are expected to
occur over the life of the investment.
• The discount factor allows the present value of a dollar
received or paid in the future to be calculated.

• Since this involves moving backward rather than forward in

time, the discount factor is the inverse of the compound
interest factor. For example, an amount of 1 dollar now will, if
invested, grow to (1+r) a year later.

• It follows that an amount B to be received in n years in the

future will have a present value of B / (1+r)n. The greater the
rate of discount used, the smaller its present value.
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Net Present Value (NPV) (Cont…)

CF0 CF1 CFn n

CFt
NPV  0
 1
 ..  n
 t
(1  r ) (1  r ) (1  r ) t 0 (1  r )
• NPV = Net present value
• CFt = Cash flow occurring at time
period (year)t (t = 0 ….n)
• n = Life of the investment
• r = discount rate
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Net Present Value (NPV) (Cont…)

• The discounted rate should be either the actual
rate of interest on long term loans in the capital
market or the interest rate paid by the borrower.

• Since capital markets do not function properly in

developing countries, the discount rate should
reflect the opportunity cost of capital. This is the
minimum rate of return below which it does not
pay to invest (Cut off rate)
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Net Present Value (NPV) (Cont…)

• The discounting period is normally equal to the life of
the investment. This period is the economic life of the
investment and varies from investment to investment.

• Having determined discount rate, The investment is

acceptable if the discounted net benefits is greater than
or equals to zero.

• The economic criterion of investment appraisal is to

accept all investements that show positive or zero NPV
at the predetermined discount rate and reject all
investements that show negative NPV. Thus, the
decisions is to accept if NPV > 0.
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Net Present Value (NPV) (Cont…)

• The nature of investment investements is such that their
benefits and costs usually occur in different periods over
time.

• The NPV of a future stream of net benefits (cash flow),

(B0 − C0), (B1 − C1), (B2 − C2), …., (Bn − Cn), can be
expressed algebraically as follows: where n denotes the
length of life of the investment.

• The expression 1 / (1+r)t is commonly referred to as the

discount factor for Year t.
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Example
Items 0 1 2 3 4 5
1. Benefits 3,247 4,571 3,525 2,339

[Link] 5000 2121 1000 1000 1000 1000

[Link] Benefit (=1-2) -5000 -2121 2247 3571 2525 1339
4. Discount factor at 6% (= 1 / 1.00 .94 .89 .84 .79 .747
(1+r)t)

5. Present values (= 4x3) -5000 -2000 +2000 3000 2000 1000

B(1 / (1+r)t )

[Link] 1000
 Example

Year 0 1 2 3 4 5

Cash flow -1,000,000 200,000 200,000 300,000 300,000 550,000

Therefore,
 1,000,000 200,000 200,000 300,000 300,000 550,000
NPV  0
 1
 2
 3
 4
 5
118,913
(1.10) (1.10) (1.10) (1.10) (1.10) (1.10)

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a) When to Accept and Reject investements

• If the NPV of the investment is 0, investors can expect to recover their
incremental investment and also earn a rate of return on their capital
that would have been earned elsewhere and is equal to the private
discount rate used to compute the present values.

• This implies that investors would be neither worse nor better off than
they would have been if they had left the funds in the capital market.

• A positive NPV for a investment means that investors can expect not
only to recover their capital investment but also to receive a rate of
return on capital higher than the discount rate.

• However, if the NPV is less than 0, investors cannot expect to earn a

rate of return equal to the discount rate, nor can they expect to recover
their invested capital, and, hence, their real net worth is expected to
decrease.
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When to Accept
• Only investements with a positive NPV are attractive to
private investors. Such investors are unlikely to pursue a
investment with a negative NPV unless there are strategic
reasons for doing so.

• Many of these strategic reasons can also be evaluated in

terms of their NPVs through the valuation of the real options
made possible by the strategic investment.

• This leads to Decision Rule 1 of the NPV criterion, which holds

under all circumstances.
• Rule 1: Do not accept any investment unless it generates a
positive NPV when discounted by the opportunity cost of
funds.
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b) Budget Constraints

• Often, investors cannot obtain sufficient funds to undertake

all the available investments that have a positive NPV.

• This is also the case for governments. When such a situation

arises, a choice must be made between the investments to
determine the subset that will maximize the NPV produced
by the investment package while fitting within the budget
constraint. Thus, Decision Rule 2 is:

• Rule 2: Within the limit of a fixed budget, choose the subset

of the available investements that maximizes the NPV.
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c) No Budget Constraints

• Independent investements

• Are investements that are not in any way substitutes for each
other.

• In such cases the decision rule is to accept the investment having

positive NPV

• Which means, if two investements have positive NPV and there is

no budget constraint both could be accepted and we do not need
to choose the one with higher NPV.
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No Budget Constraints (Cont…

• A mutually exclusive investment
• Is a investment that can only be implemented at the expense of
an alternative investment as they are in some sense substitutes
for each other.

• Example of the mutually exclusive investements includes two

versions of the same investment, say with different technology,
scale or time.

• Rule 3 The decision rule for such investements is to accept the

investment with the highest NPV
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Net Present Value (NPV) (Cont…

• NPV is on the basis of the following assumptions

• Annual outlays and receipts from each investment are known for the
entire life of the investment.

• The investment life span is known.

• There should be a rate of discount, which can be applied to every

proposal and for every time period.

• However, the information required above is not always available for every
investment.

• That means the NPV criterion may be applicable only to a limited number
of investment proposals on which relevant data as indicated are
available.
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Net Present Value (NPV) (Cont…

• Advantages of NPV Approach
• It is simple to use
• It recognize the time value of money
• It is consistent with the firm’s goal
• Limitations of the Net Present Value
• The selection of an appropriate discount rate
is one major limitation of this method
• It require detailed long-term forecast of
incremental costs and benefits of the
investement
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Net Present Value (NPV) (Cont…

• The NPV does not consider the scale of investment.
• Example,
• Consider two investments
• Investment A may have NPV of birr 5000 with initial investment of birr
50000
• Where as investement B may have NPV of birr 2500 with initial
investment of birr 10000.
• Investment A would be selected regardless of its initial capital
requirement
• The NPV rule does not consider the life of the
investment.
• It does not show the exact profitability rate of the
investment
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Net Present Value (NPV) (Cont…

Net – Present – Value Ratio

• One of the limitation of NPV is that it does not consider the

scale of the initial investment.

• If one among a number of investment alternatives has to

be chosen, the investment with the largest NPV is selected.

• This process needs some refinement

• The Net Present Value Ratio (NPVR) is an attempt to
improve this limitation.

• When there are two or more alternatives, it is advisable to

know how much investment will be required to generate
these positive NPV
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Net Present Value (NPV) (Cont…)

• The ratio of the NPV and the present value of initial
investment (PVI) is called the net-present-value ratio
(NPVR)
• This should be used for comparing alternative
investments.
NPV
NPVR 
PVI

• Given alternative investments, the one with the highest

NPVR should be chosen. However, when comparing
alternative investments, care should be taken to use the
same discount rate for all investments.
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Net Present Value (NPV) (Cont…

• Insummary, the NPV has great
advantages as a discriminatory
method as compared with
•The pay back period
•Annual rate of return, and
•Other non discount methods
• Since it takes into account the timing
of the cash flows.
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2. The Internal Rate of Return of a investment

(IRR)
• Is the discount rate at which the present value of all cash
flows is equal to the present value of the initial cash outflows.

• In other words, it is the discount rate for which the present

value of the net receipts from the investment is equal to the
present value of the investment,

• Here an attempt is made to find the discount rate which just

makes the net present value of the cash flow equal to zero.
Once the IRR is identified, the decision rule
is ‘accept the investment if the IRR is
greater than the cost of capital, say r (cost
of borrowing).
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The Internal Rate of Return

• The IRR of a investment is probably the most commonly
used assessment criterion in investment appraisal.

• This is because the concept of IRR is in some way

comparable to the profit rate of a investment.

• The method utilizes present value concept but will avoid

the arbitrary choice of a discount rate.

• The procedure used to determine the IRR is the same as

the one used to calculate the NPV.
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The Internal Rate of Return

• Instead of using a predetermined cut-off rate, several discount
will be tried until the appropriate rate is found.
• And this (IRR) represents the exact profitability of the investment

• In the NPV calculation, we assume that the discount rate is known

and used to determine the net present value of the investment.
• But in the IRR calculation, we set the net present value equal to
zero and determine the discount rate which satisfies this
condition.
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The Internal Rate of Return

The IRR calculation procedure includes
• Preparation of a cash flow table
• An estimation of any discount rate to
discount the net cash flow to the present
value
• If the NPV is positive, a higher discount
rate is applied
• If the NPV is negative at this higher rate,
the IRR must be between these two
rates.
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The Internal Rate of Return

• But, if the higher discount rate still gives a positive NPV,
the discount rate must be increased until the NPV
becomes negative.

• If the positive and negative NPVs are close to zero, a

good approximation of the IRR can be obtained, using
the linear interpolation formula.

• To illustrate the calculation of internal rate of return,

consider the cash flows of the following hypothetical
investment
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The Internal Rate of Return (Cont…)

Year Cash flow
0 -100,000
1 30,000
2 30,000
3 40,000
4 45,000
• The IRR is the value of r, which satisfies the said
condition

• Let us, begin with, say, r = 12 percent.

• The right – hand side of the above equation becomes:

30,000 + 30,000 + 40,000 + 45,000 = 107,773
(1.12) (1.12)2 (1.12)3 (1.12)4
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The Internal Rate of Return (Cont…)

• Since this value is higher than the target value of
100,000, we have to try still higher value of r.
• Now let us try r = 15 percent. This makes the right –
hand side equal to:

30,000 + 30,000 + 40,000 + 45,000 =100,806.5

(1.15) (1.15)2 (1.15)3 (1.15)4

• Thisvalue is still higher than our target value,

100,000. So we increase the value of r from 15
percent to 16 percent
30,000 + 30,000 + 40,000 + 45,000 = 98,637.5
(1.16) (1.16)2 (1.16)3 (1.16)4
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The Internal Rate of Return (Cont…)

• Now this value is less than 100,000, we conclude

that the value of r lies between 15 percent and 16
percent.

• For most of the purposes this information is

sufficient. However, if a single value is required,
we have to resort to interpolation

• For that purpose we can use the following

procedures
• (High value – Initial investment)/(High value – Lower value) = (Lower
interest rate – X) / (Lower interest rate – Higher interest rate)
The Internal Rate of Return (Cont…)

100806.5  100,000 15  X
   X 15.3718
(100,806.5  98637.5) (15  16)

• Thus, the IRR would be 15.3711

• Once the IRR is identified, the decision rule is ‘accept

the investment if the IRR is greater than the cost of
capital, say r (cost of borrowing).

• That is, all investments with an internal rate of return

greater than some target rate of return, should be
accepted.

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The Internal Rate of Return (Cont…)

• From our discussions it is clear that both the NPV and
the IRR methods can and do rank investment
investements in more rational manner than the other
methods previously considered.
• In general, it can be said that the NPV method is simpler,
easier, and more direct and more reliable.
• In some situations, both the NPV and the IRR criteria
give the same accept or reject decision.
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The Internal Rate of Return (Cont…)

• Advantages of the IRR
• Useful for international institutions like the WB
since they are dealing with different discount rate
for different countries.
• It is a measure that could be understood easily by
non-economists since it is closely related to the
concept of the return on investment.
• It is a pure number and hence allows investments of
different size to be directly compared.
• Disadvantages of IRR
• Requires detailed long term forecasts of the investments
incremental costs and benefits
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3. The Benefit Cost Ratio (BCR)

• The Benefit Cost Ratio is also called

Profitability Index (PI)
• It is defined as the ratio of the sum of the
investement’s present value of benefits to
the sum of present value of its initial
investment.
• This is given as n
Bt
 (1  r ) t
t 0
BCR  n
Ct
 (1  r ) t
t 0
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The Benefit Cost Ratio (BCR) (Cont…)

• We can define the benefit – cost ratio (BCR) in

two different ways.
a) The first definition relates the present value
of all benefits to the initial investment. This is
given by

Where: PVB
BCR = benefit – cost ratio BCR 
I
PVB = present value of benefits
I = initial investment
The Benefit Cost Ratio (BCR) (Cont…)

b) The second definition relates net present value to

initial investment

PVB  I
NBCR   BCR  1
I
• Where:
• NCBR = net benefit – cost ratio
• NPV = net present value
• PVB = present value of benefits
• I= initial investment
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The Benefit Cost Ratio (BCR) (Cont…)

• Consider a investment, which has a cost of capital 12

percent annually and the initial investment Birr 100,000

Year Benefit
1 25,000
2 40,000
3 40,000
4 50,000
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The Benefit Cost Ratio (BCR) (Cont…)

• The benefit – cost ratio measures for this investment

are:

 25000 40000 40000 50000 

BCR   2
 3
 4
 / 1000,000 1.145
 (1. 12 ) (1 . 12 ) (1 . 12 ) (1 . 12 ) 

• NBCR = 1.145 - 1 = 0.145

• The two benefits – cost ratio measures give the same signals
because the difference between them is simply unity.
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The Benefit Cost Ratio (BCR) (Cont…)

• Since benefit – cost ratio measures net present value
per Birr of outlay, it can discriminate better between
large and small investments.

• The Decision rule for BCR

• A investment is accepted if its BCR is greater than
or equal to 1 (i.e. if its discounted benefits exceed
its discounted costs).
• But if BCR is less than 1, the investment is
rejected.
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The Benefit Cost Ratio (BCR) (Cont…)

• This criterion is especially important
for ranking independent investments
since it shows the benefit per unit of
investment.

• One possible advantage of the BCR,

on top of being easy is that it is easy
to show the impact of a percentage
change in cost or benefits on the
investements viability.
 The Benefit Cost Ratio (BCR) (Cont…)

• The following decision rules can be taken as a

summary for the two criteria.

When BCR When NBCR Decision

>1 >0 Accept
=1 =0 Indifferent
?
<1 <0 Reject

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